Depreciation is one of the biggest benefits to owning commercial or income-producing real estate. It allows a property owner to save thousands on his or her tax bill each year while still reaping the other fantastic benefits to owning real estate.
What is Depreciation?
Depreciation refers to the concept of losing value over time. In general, physical assets depreciate in value as they are used and as time passes.
A common example of a depreciating asset is a car: as you use it, its value drops and continues to do so until it is worthless. The IRS classifies real estate similarly; buildings have limited lives and will wear out through time and use when they are not maintained. Technically, no man-made object will last an eternity without continual maintenance.
You may be wondering how having a depreciating property would be a good thing for an owner. Isn’t appreciation what everyone wants? You’re not wrong, but this is a different type of depreciation, one that is produced on paper and can be used for your benefit.
The Sweet Tax Benefits of Depreciation
For tax purposes, you can mark depreciation as an expense. Because of this, you can deduct it from your taxable income.
If you use your building for income producing purposes, you can depreciate it. This means that you can, on paper, lower the value of your rental property and thus the taxes that you pay on it. For residential properties, the IRS defines a building’s “useful life” to be 27.5 years, while a commercial property, like a shopping center or restaurant, has a useful life of 39 years. This means that you can spread the building’s value over that amount of years and reap the tax savings in the meantime.
The Math Behind Depreciation
Let’s look at an example. Say you buy a small apartment building for $350,000. You can only depreciate the value of the physical building, so you must first figure out the value of the land. For our purposes, let’s say the land value is $50,000, so the building itself is worth $300,000. Your depreciable value is that $300,000. Since the building is residential, you depreciate it over 27.5 years. That means that your depreciation “expense” per year is as follows:
$300,000 / 27.5 years = $10,909.09 per year
In other words, the IRS views your building as “losing” $10,909.09 per year, so you get to deduct it from your taxes each year as a business expense. The money you save on taxes in that year can then be used to invest in other things, including the building itself. This makes depreciation a very valuable tool with significant short- and long-term benefits.
As great as depreciation is, if and when you sell the building, you will have to pay taxes on the amount that you depreciated over the previous years. This is called a recapture tax.
However, the recapture tax rate is different than the income tax rate, and it would be lower than the income tax rate most of the time depending on your income bracket (currently, it is capped at 25%). This makes it advantageous to depreciate the building most of the time anyways, even if you plan on selling it, since you would likely pay a lower marginal tax rate with recapture taxes than you would have with income taxes years earlier.
At the same time, the savings from depreciation can be reinvested to produce a nice return in a different area and can offset recapture taxes even more! As the time value of money would suggest, taking the tax savings now is advantageous for allowing you to invest your money to produce a return over time.
Basically, depreciating real estate for tax purposes allows you to take the cake and eat it too.
While your property is appreciating, whether from renovations or just gradual market growth, it can bring in income which can be largely tax-free once your depreciation deduction is added! Remember, this can only be used with a property that has commercial or income producing purposes and not on a typical home.
With any tax strategy, be sure to go over it with a specialist to make sure that you are saving as much as possible on your tax bill and that you are following current laws. Tax law is obnoxiously complex, so it is typically well worth it to have someone very knowledgeable looking over your current position.